EM in ‘limbo’ provides trading and pricing challenges

Dan Barnes

Emerging market bond funds have seen outflows continue to slow significantly, with Morgan Stanley’s analysts estimating it at US$1.8 billion, equating to about 0.42% of assets under management (AuM) between 1 April and 8 April, which is lower than the US$5 billion (1.15% AUM) of outflows the broker -dealer measured in the previous week. With outflows in liquidity-challenged markets, that can create distortions in pricing.

“People sell what they can rather than what they would choose to, so you can see days where liquid names drop in price harder,” notes one buy-side EM trader. “You have also seen exchange-traded fund bid lists out for a number of days creating challenges in the market, which given they are a relatively small part of EM as a percentage of market value shows how depth can disappear.”

In a research note issued on 30 March, S&P Global Ratings observed that during the height of market volatility, “[EM] bond spreads quickly escalated to the highest levels and at the fastest pace in a decade, owing to a flight to quality.” This creates risks as weaker investor confidence will likely constrain debt issuances.

“Despite accommodative monetary policy across most emerging economies due to reduced capital needs and weakening demand for goods and services across most economies,” the firm observed.

Consequently sovereign credit default swap (CDS) spreads have rapidly expanded, signalling investor concern about sovereign financial health, widening an average of 130 bps across EMs over March, while the governments’ stimulus responses to combat the pandemic lead to increased leverage on an already highly levered market. S&P Global Ratings also noted that Argentina, Lebanon, Zambia, and Emirate of Sharjah all saw downgrades, with default in the case of Argentina and Lebanon, in 2020.

As these effects are priced into the market, banks tentatively return to EM market making and outflows reduce, traders describe the situation as being somewhat “in limbo”.

“The street are struggling to price risk either way as they cannot guess the next direction,” notes the trader. “Buy side are not buying because bid/offers are five points plus and no-one will tolerate that kind of mark-to-market.”

As pricing on all-to-all platforms is often reliant on pricing from the runs to anchor their price point, rather than being based on a risk price, they are equally challenged.

Morgan Stanley’s analysts noted that the last six weeks’ outflows have amounted to US$54.4bn (11.8% of AuM) for EM debt-dedicated (EMDD) funds, but where local funds drove most of the outflows for the previous week, the most recent outflows over the last week were spread out more evenly among all asset classes and fund types.

“One main distinction is that globally mandated funds drove 77% of this week’s outflows, a slight deterioration from the US$166 million of net inflows the week prior,” the analyst note wrote. “Much of the reduction in outflows has come on the back of significant amounts of global liquidity injection from central banks and announcements of fiscal stimulus measures globally, as well as an improvement in risk sentiment.”

©The DESK 2020